Budgets about to bust

The promise that US interest rates will stay close to zero is made against a backdrop of a looming fiscal crunch.

Congress pushed through a last-minute deal to expand the debt ceiling in mid-2011 to avoid shutting down the entire federal government. But buried in that deal was a promise that automatic spending cuts of $1.2 trillion would start on January 1, 2013.

The US economy has run budget deficits throughout the financial crisis. The US Congressional Budget Office projects a $1.1 trillion deficit in 2012, but the deficit is set to shrink dramatically.

The end of payroll tax cuts and Bush-era tax cuts means expansionary fiscal policy could come to a juddering halt, with unknown consequences for the US economy and markets.

The policy of spending more than you raise in tax has a lot of enemies in America, but it also has proponents.

Not least is Nobel Laureate for economics recipient Paul Krugman.

A fierce opponent of austerity, Mr Krugman has argued for government spending to substitute for a shortage of aggregate demand and put people back to work.

“Half a century ago, any economist . . . could have told you that austerity in the face of depression was a very bad idea," he has written.

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Bank of America Merrill Lynch chief economist in Australia,
Saul Eslake,
said austerity was once thought to be benign but, as many large economies were in an austerity phase at once, the risks were higher.

He suggested a “five-minutes-to-midnight deal" could be done to prop up spending in the US once the political conditions permitted.

“It is most unlikely any deal will be done before the presidential elections," he said.

“Therefore, as people become aware of the fiscal train wreck that is looming, confidence will erode and the economy will slow," he said, citing analysis by his Merrill Lynch colleagues.

Commonwealth Bank economist Savanth Sebastian said the deficit was a structural issue and political dynamics would impede any agreement on fiscal contraction.